Seth Klarman (Trades, Portfolio) is one of the most experienced and successful value investors managing money today.
Even if you are not a value investor, I think every investor can learn a lot from the way this hedge fund manager has managed his portfolio over the past three or four decades. There's one area in particular which I believe most investors should spend more time and effort on, and Klarman has some essential advice in this regard.
Klarman's secret
I think the single most crucial element that has helped Klarman achieve the performance he has is his focus on risk. As he has said:
"Avoiding loss is the most important prerequisite to investment success."
If you read his books and letters to investors as well as the interviews has given over the years, Klarman always tries to make it clear that risk avoidance is the most critical factor in his investment strategy.
He is not willing to sacrifice risk avoidance for performance. He is not going to buy some high-risk mining stock in the hopes of being able to generate a 100% return when the flipside is the opportunity to lose everything.
Unfortunately, it is very easy for the average investor to get starstruck with returns and overlook risk. The key is to try and avoid greed. Yes, someone is probably getting richer than you, but that is not a problem. It is much better to get rich slowly rather than trying to get rich quickly and losing everything along the way. Indeed, as Klarman once said:
"Greedy, short-term orientated investors may lose sight of a sound mathematical reason for avoiding loss; the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling."
So how does the average investor build an investment strategy focused on risk avoidance above all else, without getting distracted by the bright lights of high returns?
A strategy that Mohnish Pabrai (Trades, Portfolio) and Klarman both like to use is one of harsh grading. In other words, they want to be able to rule out the stock for investment as soon as possible, before they get distracted by the prospect of the high returns it might offer in the best-case scenario.
Both investors have suggested in the past that the best way to go about this is to start your investment process by asking the question, "how much can I lose," when evaluating every new investment.
If you cannot answer this question, or if the potential for capital loss is exceptionally high, it is worth getting rid of the idea as soon as possible.
Sure, this approach might mean that you miss out on some of the best opportunities on the market. For example, Warren Buffett (Trades, Portfolio) missed out on all of the FANG stocks because he didn't understand the sector, a move that has undoubtedly cost his investors tens of billions of dollars in potential profits.
However, a steady, certain return is much more attractive over the long-term than an uncertain high return. That's what investors should be looking for whenever they are evaluating a potential trade.
"An investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes spectacular gains but with considerable risk of principal. An investor who earns 16% annual returns over a decade, will perhaps surprisingly, end up with more money than an investor who earns 20% a year for nine years and then loses 15% the tenth year." -- Seth Klarman (Trades, Portfolio)
The bottom line
Concentrating on risk reduction won't guarantee outperformance over the long term, but it should help you avoid the worst losses.
Significant losses should be avoided at all costs because there's never a guarantee they will be compensated for by substantial gains. After all, a 50% loss requires a 100% gain to return to zero. There are far more stocks that can give you 50% than could provide a 100% gain.
Read more here:
- Charlie Munger's Makers of a Good Business
- Charlie Munger's Three Tips for Valuing Stocks
- Buffett's Advice for Improving Your Strategy: Keep Reading and Learning
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